COST OF CAPITAL

• Capital Component


  One of the types of capital used by firms to raise funds
• Investor-supplied items


  • Debt
  • Preferred stock
  • Common equity
• Increases in assets must be financed by increases in these capital components
• Component cost


  The cost of each capital component
• Weighted Average Cost of Capital (WACC)

  A weighted average of the component costs of debt, preferred stock, and common equity
• Before-tax cost of debt

  The interest rate a firm must pay on its new debt
• After-tax cost of debt

  The interest rate on new debt less tax savings that result because interest is tax deductible
• Only debt has a tax adjustment factor (1-tax rate)
• Cost of Preferred Stock

  The rate of return investors require on the firm's preferred stock
• Calculating cost of preferred stock

  Divide preferred dividend per share by the current price
• Cost of Retained Earnings

  The opportunity cost, the returns that stockholders could earn on alternative investments of comparable risk
• Cost of Common Equity

  The returns that investors require on the company's common stock
• CAPM approach to estimate cost of common equity

  1. Step 1: Estimate risk-free rate

  2. Step 2: Estimate stock's beta coefficient

  3. Step 3: Estimate market risk premium

  4. Step 4: Substitute in CAPM equation
• Risk premium


  The difference between the expected rate of return on the overall market and the risk-free rate
• Beta coefficient


  A measure of an asset's systematic risk, the sensitivity of a stock's returns to the returns on some market index
• Dividend-Yield-plus-Growth-Rate or Discounted Cash Flow (DCF) approach to estimate cost of common equity

  Cost of RE = Dividend per share / Current price + Growth rate
• The opportunity cost of equity from retained earnings is the minimum rate of return that should be earned on retained earnings
• Expected growth rate


  Return on equity x Retention ratio
• Flotation costs


  Bankers' fees and the percentage cost of issuing new common stock
• Calculating cost of new common stock

  Cost of equity from new stock = (Dividend per share / Current price (1-Flotation cost)) + Growth rate
• Calculating Weighted Average Cost of Capital (WACC)

  WACC = (Debt % x After-tax cost of debt) + (Preferred stock % x Cost of preferred stock) + (Common equity % x Cost of common equity)
• Factors affecting WACC


  • Factors the firm cannot control: Interest rates, General stock price level, Tax rates
  • Factors the firm can control: Capital structure, Dividend payout ratio, Capital budgeting decision rules